The Bailout Bill?

Does the financial regulatory bill put an end to taxpayer-funded bailouts? Or does it "institutionalize" them? Viewers of the Sunday political talk shows and recent C-SPAN clips from the Senate floor might well be wondering, as Democrats (the "end of bailouts" crowd) and some Republicans (the "institutionalize" camp) have made these contradictory claims.

No piece of legislation can guarantee that a future Congress won’t allow the federal government to prop up a failing financial institution. But claims that this bill makes taxpayer-funded bailouts a permanent fixture are misleading, to say the least.

The main point of contention is a provision that calls for a $50 billion fund to be used to liquidate a bank that’s on the verge of collapse. The bill does not authorize use of the fund to prop up companies or bail them out. Rather, it would be used to keep a troubled company operating long enough for the Federal Deposit Insurance Corporation to dismantle it. The Senate bill, which is sponsored by Democratic Sen. Chris Dodd of Connecticut, states that the fund would be available to the FDIC to be used for "the orderly liquidation of covered financial companies, payment of administrative expenses, the payment of principal and interest by the Corporation on obligations issued under paragraph (9), and the exercise of the authorities of the Corporation under this title." (The "Corporation" is the FDIC.) This fund is even called the "Orderly Liquidation Fund" in the bill.

Furthermore, while critics speak of "taxpayer-funded bailouts," the fund in question isn’t financed by ordinary taxpayers at all. The bill requires banks and financial institutions to fund it, and replenish it if funds are used. The FDIC would decide which companies have to contribute, and how much, based on an institution’s risk. The FDIC would have between five and 10 years to reach that target of $50 billion.

As for an "orderly liquidation," the bill says that would include removing the management of the company and making sure shareholders don’t get any money until other claims are paid:

SEC. 206. MANDATORY TERMS AND CONDITIONS FOR ALL ORDERLY LIQUIDATION ACTIONS.
In taking action under this title, the Corporation shall— (1) determine that such action is necessary for purposes of the financial stability of the United States, and not for the purpose of preserving the covered financial company;
(2) ensure that the shareholders of a covered financial company do not receive payment until after all other claims and the Fund are fully paid;
(3) ensure that unsecured creditors bear losses in accordance with the priority of claim provisions in section 210; and
(4) ensure that management responsible for the failed condition of the covered financial company is removed (if such management has not already been removed at the time at which the Corporation is appointed receiver).

We spoke with Harvard Business School Professor David Moss, who has researched and written about the government’s role in managing risk, about this provision in the bill. “The assessment is put on the financial firms,” Moss says. “Calling that a bailout seems inaccurate to me.”

In his opinion, Moss says, an orderly liquidation that puts the cost on financial institutions themselves is “an appropriate way to deal with it based on what we know historically.” It’s a way “to prevent the cost from falling on the taxpayer.”

Perhaps the most vocal critic of the legislation has been Senate Minority Leader Mitch McConnell, who said on the Senate floor on April 13: "This bill not only allows for taxpayer-funded bailouts of Wall Street banks; it institutionalizes them." McConnell’s argument is that the $50 billion paid in by banks and Wall Street firms will lead to federal regulators taking actions that will require additional funds from taxpayers:

Sen. McConnell, April 13: Moreover, the mere existence of this fund will ensure that it gets used. And once it’s used up, taxpayers will be asked to cover the balance. This is precisely the wrong approach

McConnell noted that during the last crisis, AIG alone received more than three times the amount of this fund from the taxpayers. It’s true that AIG was bailed out (not shut down) at a cost estimated at $182 billion. But the fact is that the fund is designed to put firms like AIG out of business in an orderly way. Putting something out of business is not ordinarily defined as a bailout. Anyway, Congress approved the last bailout, and a future Congress would have to approve or disapprove any future bailout on that scale. This bill wouldn’t repeal its control of the federal purse strings.

Not all Republicans have agreed with McConnell. GOP Rep. Bob Corker of Tennessee called out the critics for misrepresenting the bill.

Corker, April 19: But this fund that’s been set up is anything but a bailout. It’s been set up to in essence provide upfront funding by the industry so that when these companies are seized, there’s money available to make payroll and to wind it down while the pieces are being sold off.

On Sunday’s "Meet the Press," Treasury Secretary Timothy Geithner said "taxpayers will not be on the hook for bailing out these large institutions from their mistakes in the future." Instead, the banks would be. Later on the show, Republican Rep. Marsha Blackburn of Tennessee countered: "They know this is financial regulatory reform bill in its current form, that is working its way through, is — going to institutionalize the bailouts." She acknowledged that companies are the ones that pay into the liquidation fund, but said the cost would be passed along to the consumer. "Corporations don’t pay taxes, people do." Fair enough, but that still ignores the fact that the bill creates this fund to help dissolve a company, not prop it up.

The White House has said that the liquidation fund should just be nixed and replaced with a provision calling for companies to pay back any taxpayer money that might be needed for any future federal-handled dissolution. In other words, the government would pay liquidation costs and companies would have to reimburse the government.

The bailout-versus-not-a-bailout debate may be coming to an end, however. Recently, McConnell had toned down the criticism. On April 20, he said he was encouraged by bipartisan discussions. "I’m convinced now that there is a new element of seriousness attached to this, rather than just trying to score political points," he said.

The Federal Reserve

McConnell also claimed that the bill gives the Federal Reserve "enhanced emergency lending authority," while Dodd countered that this authority is "strictly restricted." We’ll score this one for Dodd.

We wrote about the Federal Reserve’s authority to lend struggling companies money in February, when a third-party group was making misleading claims about the House regulatory bill. Section 13 (3) of the Federal Reserve Act says that "[i]n unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank" to lend money to "any individual, partnership, or corporation," and it’s through that rule that the Fed lent money to AIG and Bear Sterns.

The Senate bill modifies Section 13 (3), putting more controls on the board’s ability to give out money. The legislation (Sec. 1151) says the board must set up policies governing emergency lending. "Such policies and procedures shall be designed to ensure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the collateral for emergency loans is of sufficient quality to protect taxpayers from losses."